Chapter One Basics of Economics

Introduction

Have you ever heard anything about Economics? Yes!!! It is obvious you heard about economics
and even you talked a lot about economics in your day to day activities. And you may have
questions such as: What are resources? What does efficient allocation mean? What are human
needs? What does demand mean? What is economics? This course will answer those questions
and introduce you to the nature of economics, demand and supply theories, theories of consumer,
production, cost, market structure and fundamental concepts of macroeconomics at large.

In this chapter you will be introduced to the subject matter of economics and the rationale that
motivates us to study economics.

Chapter objectives

After successful completion of this chapter, you will be able to:

 understand the concept and nature of economics;

 analyze how resources are efficiently used in producing output;
 identify the different methods of economic analysis ;
 distinguish and appreciate the different economic systems;
 understand the basic economic problems and how they can be solved; and
 identify the different decision making units and how they interact with each other
1.1 Definition of Economics

Economics is a social science which studies about efficient allocation of scarce resources so as
to attain the maximum fulfillment of unlimited human needs. As economics is a science of
choice, it studies how people choose to use scarce or limited productive resources (land,
labour, equipment, technical knowledge and the like) to produce various commodities.

The following statements are derived from the above definition.

 Economics studies about scarce resources;

 It studies about allocation of resources;
 Allocation should be efficient;
 Human needs are unlimited

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  The aim (objective) of economics is to study how to satisfy the unlimited human needs
up to the maximum possible degree by allocating the resources efficiently.
1.2 The rationales of economics
There are two fundamental facts that provide the foundation for the field of economics.

 Human (society‘s) material wants are unlimited.

 Economic resources are limited (scarce).
The basic economic problem is about scarcity and choice since there are only limited amount
of resources available to produce the unlimited amount of goods and services we desire. Thus,
economics is the study of how human beings make choices to use scarce resources as they seek
to satisfy their unlimited wants. Therefore, choice is at the heart of all decision-making. As an
individual, family, and nation, we confront difficult choices about how to use limited resources
to meet our needs and wants. Economists study how these choices are made in various settings;
evaluate the outcomes in terms of criteria such as efficiency, equity, and stability; and search for
alternative forms of economic organization that might produce higher living standards or a more
desirable distribution of material well-being.

1.3 Scope and method of analysis in economics

1.3.1 Scope of economics
The field and scope of economics is expanding rapidly and has come to include a vast range of
topics and issues. In the recent past, many new branches of the subject have developed, including
development economics, industrial economics, transport economics, welfare economics,
environmental economics, and so on. However, the core of modern economics is formed by its
two major branches: microeconomics and macroeconomics. That means economics can be
analyzed at micro and macro level.

Microeconomics is concerned with the economic behavior of individual decision making units
such as households, firms, markets and industries. In other words, it deals with how households
and firms make decisions and how they interact in specific markets.

Macroeconomics is a branch of economics that deals with the effects and consequences of the
aggregate behaviour of all decision making units in a certain economy. In other words, it is an
aggregative economics that examines the interrelations among various aggregates, their

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 determination and the causes of fluctuations in them. It looks at the economy as a whole and
discusses about the economy-wide phenomena.

Microeconomics Macroeconomics
 Studies individual economic units of an  Studies an economy as a whole and
economy. its aggregates.
 Deals with individual income, individual  Deals with national income and output
prices, individual outputs, etc. and general price level
 Its central problem is price  Its central problem is determination of
determination and allocation of level of income and employment.
resources.  Its main tools are aggregate demand and
 Its main tools are the demand and supply aggregate supply of an economy as a
of particular commodities and factors. whole.
 It helps to solve the central problem of  Helps to solve the central problem of

what, how and for whom to produce‘ in an full employment of resources in the
economy so as to maximize profits economy.‘
 Discusses how the equilibrium of a  Concerned with the determination of
consumer, a producer or an industry equilibrium levels of income and
is attained. employment at aggregate level.
Examples: Individual income, individual Examples: national income, national
savings, individual prices, an individual firm‘s savings, general price level, national output,
output, individual consumption, etc. aggregate consumption, etc.
Note: Both microeconomics and macroeconomics are complementary to each other. That is,
macroeconomics cannot be studied in isolation from microeconomics.

1.3.2 Positive and normative analysis

Is economics a positive science or normative science, or both? What is your justification?

Economics can be analyzed from two perspectives: positive economics and normative
economics.

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Positive economics: it is concerned with analysis of facts and attempts to describe the world as
it is. It tries to answer the questions what was; what is; or what will be? It does not judge a
system as good or bad, better or worse.

Example:

 The current inflation rate in Ethiopia is 200 percent.

 Poverty and unemployment are the biggest problems in Ethiopia.
 The life expectancy at birth in Ethiopia is rising.
All the above statements are known as positive statements. These statements are all concerned
with real facts and information. Any disagreement on positive statements can be checked by
looking in to facts.

Normative economics: It deals with the questions like, what ought to be? Or what the
economy should be? It evaluates the desirability of alternative outcomes based on one‘s value
judgments about what is good or what is bad. In this situation since normative economics is
loaded with judgments, what is good for one may not be the case for the other. Normative
analysis is a matter of opinion (subjective in nature) which cannot be proved or rejected with
reference to facts.

Example:

 The poor should not be pay taxes.

 There should be a need for intervention of government in the economy.
 Females ought to be given job opportunities.
Any disagreement on a normative statement can be solved by voting.

1.3.3 Inductive and deductive reasoning in economics

The fundamental objective of economics, like any science, is the establishment of valid
generalizations about certain aspects of human behaviour. Those generalizations are known as
theories. A theory is a simplified picture of reality. Economic theory provides the basis for
economic analysis which uses logical reasoning. There are two methods of logical reasoning:
inductive and deductive.

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Inductive reasoning is a logical method of reaching at a correct general statement o r theory
based on several independent and specific correct statements. In short, it is the process of
deriving a principle or theory by moving from facts to theories and from particular to general
economic analysis.

Inductive method involves the following steps.

 Selecting problem for analysis

 Collection, classification, and analysis of data
 Establishing cause and effect relationship between economic phenomena.
Deductive reasoning is a logical way of arriving at a particular or specific correct statement
starting from a correct general statement. In short, it deals with conclusions about economic
phenomenon from certain fundamental assumptions or truths or axioms through a process of
logical arguments. The theory may agree or disagree with the real world and we should check the
validity of the theory to facts by moving from general to particular.

Major steps in the deductive approach include:

 Problem identification
 Specification of the assumptions
 Formulating hypotheses
 Testing the validity of the hypotheses
1.4 Scarcity, choice, opportunity cost and production possibilities frontier

1. Have you ever faced a problem of choice among different alternatives? If yes,
what was your decision?
2. What is scarcity? Do you think that it is different from shortage? Why?

It is often said that the central purpose of economic activity is the production of goods and
services to satisfy consumer‘s needs and wants i.e. to meet people‘s need for consumption both
as a means of survival and also to meet their ever growing demand for an improved life style or
standard of living.

1. Scarcity

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The fundamental economic problem that any human society faces is the problem of scarcity.
Scarcity refers to the fact that all economic resources that a society needs to produce goods and
services are finite or limited in supply. But their being limited should be expressed in relation
to human wants. Thus, the term scarcity reflects the imbalance between our wants and the means
to satisfy those want.

Resources can be categorized as free resources (that are free gifts of nature, are unlimited in
supply) and economic resources (that are scarce such as land, labor, capital and
entrepreneurship).

The following are examples of scarce resources.

 All types of human resources: manual, intellectual, skilled and specialized labor;
 Most natural resources like land (especially, fertile land), minerals, clean water, forests
and wild - animals;
 All types of capital resources ( like machines, intermediate goods, infrastructure ); and
 All types of entrepreneurial resources.
 Economic resources are usually classified into four categories.
Labour: refers to the physical as well as mental efforts of human beings in the production and
distribution of goods and services. The reward for labour is called wage.

Land: refers to the natural resources or all the free gifts of nature usable in the production of
goods and services. The reward for the services of land is known as rent.

Capital: refers to all the manufactured inputs that can be used to produce other goods and
services. Example: equipment, machinery, transport and communication facilities, etc. The
reward for the services of capital is called interest.

Entrepreneurship: refers to a special type of human talent that helps to organize and manage
other factors of production to produce goods and services and takes risk of making loses. The
reward for entrepreneurship is called profit.

Entrepreneurs are individuals who:

 Organize factors of production to produce goods and services.

 Make basic business policy decisions.

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  Introduce new inventions and technologies into business practice.
 Look for new business opportunities.
 Take risks of making losses.
Note: Scarcity does not mean shortage. We have already said that a good is said to be scarce if
the amount available is less than the amount people wish to have at zero price. But we say that
there is shortage of goods and services when people are unable to get the amount they want at the
prevailing or on going price. Shortage is a specific and short term problem but scarcity is a
universal and ever lasting problem.

2. Choice

If resources are scarce, then output will be limited. If output is limited, then we cannot satisfy all
of our wants. Thus, choice must be made. Due to the problem of scarcity, individuals, firms and
government are forced to choose as to what output to produce, in what quantity, and what output
not to produce. In short, scarcity implies choice. Choice, in turn, implies cost. That means
Scarcity → limited resource → limited output → we might not satisfy all our wants
→choice involves costs → opportunity cost
whenever choice is made, an alternative opportunity is sacrificed. This cost is known as
opportunity cost.

3. Opportunity cost

In a world of scarcity, a decision to have more of one thing, at the same time, means a decision
to have less of another thing. The value of the next best alternative that must be sacrificed is,
therefore, the opportunity cost of the decision.

Definition: Opportunity cost is the amount or value of the next best alternative that must be
sacrificed (forgone) in order to obtain one more unit of a product.

For example, suppose the country spends all of its limited resources on the production of cloth or
computer. If a given amount of resources can produce either one meter of cloth or 20 units of
computer, then the cost of one meter of cloth is the 20 units of computer that must be sacrificed
in order to produce a meter of cloth.

In conclusion, when opportunity cost of an activity increases people substitute other activities
in its place.

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4. The Production Possibilities Frontier or Curve (PPF/ PPC)

The production possibilities frontier (PPF) is a curve that shows the various possible
combinations of goods and services that the society can produce given its resources and
technology. To draw the PPF we need the following assumptions.

a. The quantity as well as quality of economic resource available for use during the year is
fixed.
b. There are two broad classes of output to be produced over the year.
c. The economy is operating at full employment and is achieving full production
(efficiency).
d. Technology does not change during the year.
e. Some inputs are better adapted to the production of one good than to the production of
the other (specialization).
Suppose a hypothetical economy produces food and computer given its limited resources and
available technology (table 1.1).

Types of products Unit Production alternatives

A B C D E
Food metric tons 500 420 320 180 0
Computer number 0 500 1000 1500 2000
We can also display the above information with a graph.

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The PPF describes three important concepts:

The concepts of scarcity: - the society can not have unlimited amount of outputs even if it
employs all of its resources and utilizes them in the best possible way.

The concept of choice: - any movement along the curve indicates the change in choice.

The concept of opportunity cost: - when the economy produces on the PPF, production of more
of one good requires sacrificing some of another product which is reflected by the downward
sloping PPF. Related to the opportunity cost we have a law known as the law of increasing
opportunity cost. This law states that as we produce more and more of a product, the
opportunity cost per unit of the additional output increases. This makes the shape of the PPF
concave to the origin.

The reason why opportunity cost increases when we produce more of one good is that economic
resources are not completely adaptable to alternative uses (specialization effect).

Example: Referring to table 1.1 above, if the economy is initially operating at point B, what is
the opportunity cost of producing one more unit of computer?

Solution: Moving from production alternative B to C we have:

Example: Referring to table 1.1 above, if the economy is initially operating at point B, what is
the opportunity cost of producing one more unit of computer?

1.5 Basic economic questions

Economic problems faced by an economic system due to scarcity of resources are known as
basic economic problems. These problems are common to all economic systems. They are also
known as central problems of an economy. Therefore, any human society should answer the
following three basic questions.

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What to Produce?

This problem is also known as the problem of allocation of resources. It implies that every
economy must decide which goods and in what quantities are to be produced. The economy must
make choices such as consumption goods versus capital goods, civil goods versus military
goods, and necessity goods versus luxury goods. As economic resources are limited we must
reduce the production of one type of good if we want more of another type. Generally, the final
choice of any economy is a combination of the various types of goods but the exact nature of the
combination depends upon the specific circumstances and objectives of the economy.

How to Produce?

This problem is also known as the problem of choice of technique. Once an economy has reached
a decision regarding the types of goods to be produced, and has determined their respective
quantities, the economy must decide how to produce them - choosing between alternative
methods or techniques of production. For example, cotton cloth can be produced with hand
looms, power looms, or automatic looms. Similarly, wheat can be grown with primitive tools and
manual labour, or with modern machinery and little labour.

Broadly speaking, the various techniques of production can be classified into two groups:
labour-intensive techniques and capital-intensive techniques. A labour-intensive technique
involves the use of more labour relative to capital, per unit of output. A capital-intensive
technique involves the use of more capital relative to labour, per unit of output. The choice
between different techniques depends on the available supplies of different factors of production
and their relative prices. Making good choices is essential for making the best possible use of
limited resources to produce maximum amounts of goods and services.

For Whom to Produce?

This problem is also known as the problem of distribution of national product. It relates to how
material product is to be distributed among the members of a society. The economy must decide,
for example, whether to produce for the benefit of the few rich people or for the large number of
poor people. An economy that wants to benefit the maximum number of persons would first try
to produce the necessities of the whole population and then to proceed to the production of
luxury goods.

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All these and other fundamental economic problems center around human needs and wants.
Many human efforts in society are directed towards the production of goods and services to
satisfy human needs and wants. These human efforts result in economic activities that occur
within the framework of an economic system.

1.6 Economic systems

The way a society tries to answer the above fundamental questions is summarized by a concept
known as economic system. An economic system is a set of organizational and institutional
arrangements established to answer the basic economic questions. Customarily, we can identify
three types of economic system. These are capitalism, command and mixed economy.

1.6.1 Capitalist economy

Capitalism is the oldest formal economic system in the world. It became widespread in the
middle of the 19th century. In this economic system, all means of production are privately owned,
and production takes place at the initiative of individual private entrepreneurs who work mainly
for private profit. Government intervention in the economy is minimal. This system is also called
free market economy or market system or laissez faire.

Features of Capitalistic Economy

 The right to private property: The right to private property is a fundamental feature of
a capitalist economy. As part of that principle, economic or productive factors such as
land, factories, machinery, mines etc. are under private ownership.
 Freedom of choice by consumers: Consumers can buy the goods and services that suit
their tastes and preferences. Producers produce goods in accordance with the wishes of
the consumers. This is known as the principle of consumer sovereignty.
 Profit motive: Entrepreneurs, in their productive activity, are guided by the motive of
profit-making.
 Competition: In a capitalist economy, competition exists among sellers or producers of
similar goods to attract customers. Among buyers, there is competition to obtain goods.
Among workers, the competition is to get jobs. Among employers, it is to get workers
and investment funds.
 Minor role of government: The government does not interfere in day-to-day

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 economic activities and confines itself to defense and maintenance of law and order.
 Self-interest: Each individual is guided by self-interest and motivated by the desire
for economic gain.
 Inequalities of income: There is a wide economic gap between the rich and the poor.
 Existence of negative externalities: A negative externality is the harm, cost, or
inconvenience suffered by a third party because of actions by others. In capitalistic
economy, decision of firms may result in negative externalities against another firm or
society in general.
Advantages of Capitalistic Economy

 Flexibility or adaptability: It successfully adapts itself to changing environments.

 Decentralization of economic power: Market mechanisms work as a decentralizing
force against the concentration of economic power.
 Increase in per-capita income and standard of living: Rapid growth in levels of
production and income leads to higher per-capita income and standards of living.
 New types of consumer goods: Varieties of new consumer goods are developed and
produced at large scale.
 Growth of entrepreneurship: Profit motive creates and supports new entrepreneurial
skills and approaches.
 Optimum utilization of productive resources: Full utilization of productive resources
is possible due to innovations and technological progress.
 High rate of capital formation: The right to private property helps in capital formation.
Disadvantages of Capitalistic Economy

 Inequality of income: Capitalism promotes economic inequalities and creates social

imbalance.
 Unbalanced economic activity: As there is no check on the economic system, the
economy can develop in an unbalanced way in terms of different geographic regions and
different sections of society.
 Exploitation of labour: In a capitalistic economy, exploitation of labour (for example by
paying low wages) is common.
 Negative externalities: are problems in capitalistic economy where profit maximization

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 is the main objective of firms. If economic makes sense for a firm to force others to pay
the impacts of negative externalities such as pollution.
1.6.2 Command economy

Command economy is also known as socialistic economy. Under this economic system, the
economic institutions that are engaged in production and distribution are owned and controlled
by the state. In the recent past, socialism has lost its popularity and most of the socialist countries
are trying free market economies.

Main Features of Command Economy

 Collective ownership: All means of production are owned by the society as a whole, and
there is no right to private property.
 Central economic planning: Planning for resource allocation is performed by the
controlling authority according to given socio-economic goals.
 Strong government role: Government has complete control over all economic activities.
 Maximum social welfare: Command economy aims at maximizing social welfare and
does not allow the exploitation of labour.
 Relative equality of incomes: Private property does not exist in a command economy,
the profit motive is absent, and there are no opportunities for accumulation of wealth. All
these factors lead to greater equality in income distribution, in comparison with
capitalism.
Advantages of Command Economy

 Absence of wasteful competition: There is no place for wasteful use of productive

resources through unhealthy competition.
 Balanced economic growth: Allocation of resources through centralized planning leads
to balanced economic development. Different regions and different sectors of the
economy can develop equally.
 Elimination of private monopolies and inequalities: Command economies avoid the
major evils of capitalism such as inequality of income and wealth, private monopolies,
and concentration of economic, political and social power.
Disadvantages of Command Economy

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  Absence of automatic price determination: Since all economic activities are controlled
by the government, there is no automatic price mechanism.
 Absence of incentives for hard work and efficiency: The entire system depends on
bureaucrats who are considered inefficient in running businesses. There is no financial
incentive for hard work and efficiency. The economy grows at a relatively slow rate.
 Lack of economic freedom: Economic freedom for consumers, producers, investors, and
employers is totally absent, and all economic powers are concentrated in the hands of the
government.
 Red tapism: it is widely prevalent in a command economy because all decisions are
made by government officials.
1.6.3Mixed economy

A mixed economy is an attempt to combine the advantages of both the capitalistic economy and
the command economy. It incorporates some of the features of both and allows private and
public sectors to co-exist.

Main Features of Mixed Economy

Co-existence of public and private sectors: Public and private sectors co-exist in this
system. Their respective roles and aims are well-defined. Industries of national and
strategic importance, such as heavy and basic industry, defense production, power
generation, etc. are set up in the public sector, whereas consumer-goods industry and
small-scale industry are developed through the private sector.
Economic welfare: Economic welfare is the most important criterion of the success of a
mixed economy. The public sector tries to remove regional imbalances, provides large
employment opportunities and seeks economic welfare through its price policy.
Government control over the private sector leads to economic welfare of society at large.
Economic planning: The government uses instruments of economic planning to achieve
co-ordinated rapid economic development, making use of both the private and the public
sector.
Price mechanism: The price mechanism operates for goods produced in the private
sector, but not for essential commodities and goods produced in the public sector. Those
prices are defined and regulated by the government.

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 Economic equality: Private property is allowed, but rules exist to prevent concentration
of wealth. Limits are fixed for owning land and property. Progressive taxation,
concessions and subsides are implemented to achieve economic equality.
Advantages of Mixed Economy

 Private property, profit motive and price mechanism: All the advantages of a
capitalistic economy, such as the right to private property, motivation through the profit
motive, and control of economic activity through the price mechanism, are available in
mixed economy. At the same time, government control ensures that they do not lead to
exploitation.
 Adequate freedom: Mixed economies allow adequate freedom to different economic
units such as consumers, employees, producers, and investors.
 Rapid and planned economic development: Planned economic growth takes place,
resources are properly and efficiently utilized, and fast economic development takes
place because the private and public sector complement each other.
 Social welfare and fewer economic inequalities: The government‘s restricted control
over economic activities helps in achieving social welfare and economic equality.
Disadvantages of Mixed Economy

 Ineffectiveness and inefficiency: A mixed economy might not actually have the usual
advantages of either the public sector or the private sector. The public sector might be
inefficient due to lack of responsibility, and the private sector might be made ineffective
by government regulation and control.
 Economic fluctuations: If the private sector is not properly controlled by the
government, economic fluctuations and unemployment can occur.
 Corruption and black markets: if government policies, rules and directives are not
effectively implemented, the economy can be vulnerable to increased corruption and
black market activities.
1.7. Decision making units and the circular flow model

There are three decision making units in a closed economy. These are households, firms and
the government.

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Household: A household can be one person or more who live under one roof and make
joint financial decisions. Households make two decisions.

 Selling of their resources, and

 Buying of goods and services.
Firm: A firm is a production unit that uses economic resources to produce goods and services.
Firms also make two decisions:

 Buying of economic resources

 Selling of their products.
Government: A government is an organization that has legal and political power to control or
influence households, firms and markets. Government also provides some types of goods and
services known as public goods and services for the society.

The three economic agents interact in two markets:

Product market: it is a market where goods and services are transacted/ exchanged. That is, a
market where households and governments buy goods and services from business firms.

Factor market (input market): it is a market where economic units transact/exchange factors
of production (inputs). In this market, owners of resources (households) sell their resources to
business firms and governments.

The circular-flow diagram is a visual model of the economy that shows how money (Birr),
economic resources and goods and services flows through markets among the decision making
units.

For simplicity, let‘s first see a two sector model where we have only households and business
firms. In this case, therefore, we see the flow of goods and services from producers to
households and a flow of resources from households to business firms.

In the following diagram, the clock – wise direction shows the flow of economic resources and
final goods and services. Business firms sell goods and services to households in product
markets (upper part of the diagram). On the other hand, the lower part shows, where households
sell factors of production to business firms through factor market. The anti clock wise direction
indicates the flow of birr (in the form of revenue, income and spending on consumption). Firms,

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by selling goods and services to households, receive money in the form of revenue which is
consumption expenditure for households in the product market. On the other hand, households
by supplying their resources to firms receive income. This represents expenditure by firms to
purchase factors of production which is used as an input to produce goods and services.

A Two sector model

MARKETS
Revenue FOR Spending

GOODS AND SERVICES

• Firms sell
Goods Goods and
services

FIRMS HOUSEHOLDS

•Produce and sell • Buy and consume

goods and services goods and services
•Hire and use factors •Own and sell factors

Factors of MARKETS Labour, land,

production FOR and capital

FACTORS OF PRODUCTION
Wages, rent, and
interest •
Households sell Income
= Flow of inputs
and outputs

= Flow of Birr

Figure 1.4: Circular flow of income with two sector model

We have also a three sector model in which the government is involved in the economic
activities. As shown in figure 1.5 below, the only difference of the three sector model from the
two sector model is that it involves government participation in the market. The government to
provide public services purchase goods and services from business firms through the product
market with a given amount of expenditure. On the other hand, the government also needs

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resources required for the provision of the services. This resource is purchased from the factor
market by making payments to the resource owners (households).

A Three sector model

MARKETS
Revenue
FOR Spending

GOODS AND SERVICES

Goods
Goods and
• Firms sell
and services Goods services
sold and services sold bought
Expenditure
GOVERNMENT
Subsidy • Provide social Income support
services
FIRMS HOUSEHOLDS
Taxes • Provide supports Taxes
• Produce • Collect taxes • Buy and
and sell goods and • Buy goods and consume
services Gov’t services Gov’t services goods and services
services
• Hire and • Hire and uses
factors of production

Factors of Payments
Factors of production Labour, land,
production MARKETS and capital

FACTORS OFFOR
PRODUCTION Income
Wages, rent,
• Households sell
= Flow of inputs
and interest • Firms buy
and outputs

= Flow of Birr

Figure 1.5: Three sector circular flow of resources

The service provided by the government goes to the households and business firms. The
government might also support the economy by providing income support to the households and
subsidies to the business firms. At this point you might ask the source of government finance to
make the expenditures, payments and additional supports to the firms and households. The main
source of revenue to the government is the tax collected from households and firms.

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